Tax & Sports Update

Choosing the Right Business Vehicle: An Automotive Analogy

Posted by Joseph B. Darby III on Sep 16, 2015 9:05:00 AM

car.jpgWe live in the Era of the Limited Liability Company (LLC).

The LLC has become the dominant business vehicle of the early 21st Century:  It is the “must use” vehicle for all real estate transactions, and an increasingly popular choice for operating a commercial business as well.

How did this come to pass? The short answer is that the LLC is the most flexible business vehicle available. It is not the perfect choice for every situation, but it is the best choice for a majority of situations these days, and its use is likely to continue to burgeon for several reasons, all of which are most easily explained using automotive vehicular metaphors.

The Vehicular Metaphor

Business vehicles and automotive vehicles sometimes have interesting similarities and parallel characteristics. The following is a tax lawyer’s guide to automobiles – or, if you prefer, a car dealer’s guide to business tax planning.

C Corporation. The C corporation is like your father’s Cadillac. It is a big, roomy, comfortable business vehicle that can fit everyone inside and bring them along for the ride. The trouble with a C corporation is that, as a business vehicle, it gets very poor tax mileage. It is a tax guzzler, the way the big heavy Cadillacs were gas guzzlers in the days of yore. If you want to get to your destination easily and comfortably, and you don’t care very much about the operating costs, a C corporation is the business vehicle for you. If, however, you want to operate on a lean, efficient basis, look elsewhere on the business car lot.

S Corporation. The S corporation is like a 1973 Honda Civic. The early Civic was a two-seater, and it was extremely small and uncomfortable unless you weighed about 140 pounds (which, fortunately, I then did) but it got unbelievable gas mileage. It wasn’t a vehicle that everyone could fit into, but if you could squeeze in then it was extremely efficient. Similarly, an S corporation it not for everyone: It cannot have a corporate shareholder, cannot have a nonresident alien shareholder, cannot have a partnership as a shareholder, and can only have a limited number of shareholders, among its many significant limitations. The S corporation, like the early Civic, is a great vehicle, but only some people get the opportunity to ride in it.

General Partnership. The general partnership is the business equivalent of the 1973 Ford Pinto. The Pinto was a fabulous car to drive until you got rear-ended, at which point the gas tank exploded. OOPS! The general partnership has similar characteristics.  It is extremely easy to form, manage and operate – until something bad happens, at which point the general partnership explodes. All general partners have joint and several liability for the full liabilities and debts of the general partnership. A five-person general partnership has been described as every partner having 20% of the upside and 100% of the downside. If you know you will never have an accident, a 1973 Ford Pinto is a darn good car; the problem is, we never know in life, and so it is better to hope for the best but plan for the worst. Few people use the general partnership as a business vehicle in the litigation-happy modern era.

Limited Partnership. The limited partnership is like a racing car built by Ferdinand Porsche during the 1930s called the Silver Arrow. The Silver Arrow was the fastest car in the world at the time. The engine had 16 cylinders and generated 550 horsepower. The problem with the Silver Arrow was that it was phenomenally difficult to drive. Only a limited number of people ever learned to drive the car to its maximum potential, and several of those people died while driving the car.

Likewise, in the 1980s, the limited partnership was a phenomenally powerful business vehicle for its time, but it was extremely difficult to operate, especially for a commercial business. A limited partnership requires that the limited partners can take no active role in the partnership business. The limited partnership instead is managed by a general partner, which in the 1980s was often an incorporated entity. The individuals actually running the partnership were the officers and employees of the corporate general partner, and the insuperable complexity of the business structure often lead to dangerous and life-threatening errors.

I once had a client who was the president of the corporate general partner, which in turn signed on behalf of the limited partnership. He was forever signing bank loans and other important documents and then identifying himself as “President of the Partnership.” That was a very august and solemn sounding office, but unfortunately it did not exist:  he was the president of the corporate general partner, which in turn was the general partner of the partnership, but he was not “President of the Partnership.” It was kind of like calling himself “King of the United States,” another impressive-sounding title that doesn’t exist. What happens when you borrow a million dollar from the bank and then sign the loan using a nonsensical title? Inquiring minds prefer not to find out.

Yet aother problem was that my client, the President of the Partnership/King of the United States, regularly deposited partnership funds into whatever bank he went to next:  the partnership account, the corporate general partner account, his personal account.  The result was on on-going financial mess. In its time the limited partnership was the fastest business vehicle going – until you crashed, which happened too easily and too often.

LLC. The LLC is the business equivalent of the 1957 Chevrolet. When I was in high school in the 1960s, the 1957 Chevy was 10 years old and there were about a zillion of them in circulation. You could buy a 1957 Chevy for $50, and so just about everybody in my high school had one. You could strip a 1957 Chevy down to the chassis and build your dream car. Friends put in souped-up engines, dual and quad carburetors, metal-flake paint jobs, chrome exhaust pipes on either side of the rocker panels and a pair of dice hanging from the rearview mirror – just like the cars in the movie American Graffiti. Awesome.

The LLC has the same fundamental characteristics as the 1957 Chevy:  It is a chassis on which you can build the business vehicle of your dreams. A corporation is more like a factory automobile – it comes exactly the same way every time. With an LLC, by contrast, you can trick out the vehicle in whatever manner you want. You can create company officers like president, treasurer and secretary – or not. (A corporation is required to have a president, treasurer and secretary under Massachusetts law.) You can have annual meetings – or not. (A corporation is required to hold meetings.) You can have a Board of Directors — or not. (Every corporation must have a Board of Directors.) Anything goes with an LLC, just as long as you write it down in the operating agreement.

I once drafted an LLC operating agreement for a good friend and client with a great sense of humor, and , because the client and I had not yet discussed what formal offices and titles he wanted for the LLC, I inserted his name and gave him the title “Sun King.” A few days later I called him to review the document, and I asked him what actual title he would like to give himself. He responded, “I am going to stick with the title Sun King. You said I can give myself any title I want, and I love that title. I AM the Sun King.” A true story.

The point is that the LLC is a highly flexible, all-terrain vehicle, and in many cases this hallmark flexibility makes the LLC the perfect choice of business vehicle.  However, the LLC’s most popular competitor  is the S corporation – that simple, prosaic 1973 Honda Civic, which is extremely easy to set up (an S corporation is essentially a straight-from-the-factory business vehicle), and very easy to operate. People intuitively understand how an S corporation operates, while an LLC requires a greater level of administrative and accounting sophistication.

In the end, choosing the right business vehicle depends almost entirely on what purpose you want it to serve. If you want to jump in the car and drive to the store to buy milk, or the business equivalent, an S corporation may well be a perfect vehicle for that role, because it is cheap and easy to operate. On the other hand, if you have sophisticated needs or uses, the all-terrain flexibility may make the LLC the optimal choice.

You can of course go public, or take investments from venture capital investors, in which case you will want to jump into the C corporation, that roomy, if tax inefficient, Cadillac of business vehicles.

Finally, do not under any circumstances try to drive down the highway of life in a general partnership.  The world is the full of people who drive too fast, and so you don’t want to drive in the business fast lane in the legal equivalent of the 1973 Ford Pinto.

Topics: Tax Law, S Corporation, LLC, Limited Partnership

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